House Price Analysis: Price-To-Rent, Price-To-Income

US house prices have dropped 23% from their peak, and the rate of decline continues to accelerate. Based on today's Case Shiller index, we continue to believe prices will drop 40% from peak to trough--a bigger decline than in the Great Depression.

If prices do drop this far, they will "overshoot" fair value, as is typical in the aftermath of a bubble like the one we just had. Even with a 23% decline, however, prices still haven't hit fair value.

How do we know?

The two best valuation measures for houses are price-to-income and price-to-rent. Calculated Risk posted analysis of both ratios today, and both suggest that prices still have further to fall even before they begin to overshoot. We have reproduced Calculated Risk's excellent charts and commentary below. Here is their full commentary >

Price To Rent

This graph shows the price to rent ratio (Q1 1997 = 1.0) for the Case-Shiller national Home Price Index. For rents, the national Owners' Equivalent Rent from the BLS is used.

Looking at the price-to-rent ratio based on the Case-Shiller index, the adjustment in the price-to-rent ratio is probably 60% to 70% complete as of Q3 2008 on a national basis. This ratio will probably continue to decline with some combination of falling prices, and perhaps, rising rents. The ratio may overshoot too.

Price-to-rent ratios are useful, but somewhat flawed. They give a general idea about house prices, but there are other important factors (like inventory levels, price to income and credit issues). We are getting closer on prices, but it appears we still have a ways to go.

Price To Income

This graph shows the price-to-income ratio and is based off the Case-Shiller national index, and the Census Bureau's median income Historical Income Tables - Households (and an estimate of 2% increase in household median income for 2008).

Using national median income and house prices provides a gross overview of price-to-income (it would be better to do this analysis on a local area). However this does shows that the price-to-income is still too high, and that this ratio needs to fall another 15% or so. The further decline in this ratio could be a combination of falling house prices and/or rising nominal incomes (Note: this uses nominal incomes, and even if real incomes are stagnate or declining, nominal incomes usually are rising).

Last quarter this index was over 1.25. Now it is close to 1.2. At this pace the index will hit 1.0 in Q3 2009. However, during a recession, nominal household median incomes are usually stagnate - so it might take even longer.